Stock markets: white knuckles and shaky knees

As nervousness among investors mount in the wake of the gyrations of financial markets, the key question remains whether something more serious than a normal (and overdue) mid-cycle correction is starting to manifest itself.

On the fundamental front, the credit bubble would appear to have been irreparably punctured and, failing bail-out actions by the Fed, it could take a while for the turbidity to dissipate. More so, hedge funds and LBO players, who have fuelled part of the stock market’s excitement on the back of easy credit, have had their wings clipped for the time being.

To add insult to injury, the Japanese yen is rallying strongly and threatening the carry trade, thereby removing one of the most powerful tailwinds of the global equities bull market. The following graph depicts the strong inverse relationship between the yen index (blue line) and the Dow Jones World Stock Index (as a proxy for global equities) (black/red line):

Source: StockCharts.com

In search of direction, let’s have a look at what the stock market itself is telling us. The prognosis, unfortunately, is not particularly good, as shown by the weekly chart of the S&P 500 Index.

Source: StockCharts.com

The most important observation is that the 200-day moving average, very often seen as an indicator of the market’s primary trend, has been broken. Yes, false breaks do occur, but the fact that the decline was characterized by heavy volume gives more credence to the break. The MACD oscillator, now only in its second week in negative territory, also points to more downside potential.

One of the worst casualties of the stock market sell-off has been small caps as illustrated by the Russell 2000 Small Cap Index below.

Source: StockCharts.com

Also focus on the bottom section of the diagram, which shows that small-cap stocks are underperforming badly relative to large caps. This is typical of down-markets as large caps are seen as being more defensive and it provides further evidence that there could be more declines in store for stock markets in general.

One of the few safe places to hide from the markets’ turmoil over the past two weeks was US bonds as yields declined sharply as shown by the weekly graph of the US 10-year Treasury Note yield.

Source: StockCharts.com

Here again we see the 200-day moving average being broken (although a fair bit of whiplashing was experienced in the past), together with a sell signal from the MACD indicator. This is telling us that the bond market is expecting weaker economic activity – a scenario not liked by the stock market as a result of the possible negative implications for corporate earnings, the principal driver of stock prices over time.

Market participants’ greed and complacency have at long last started making way for concern. I am cognizant of the fact that many parts of the world economy are performing very well, and that they will probably continue to do so for many years as infrastructure is being established for billions of new entrants into the economic system. Although this can soften the impact of the credit squeeze and limit price declines, I have a nagging feeling more fear first needs to set in before great value will return to stock markets and the current chapter play itself out.

3 comments to Stock markets: white knuckles and shaky knees

I would be surprised if we don’t see more downside in due course, but the market has become quite oversold over the short term which makes a rally a distinct possibilty. One will have to watch the market breadth, volume, etc. quite closely in order to determine the staying power of a rally.